Revenue Structures, The Perceived Price of Government Output, and Public Expenditures

Abstract

This article examines how revenue structures, through fiscal illusion effects, influence government spending. It does so with a regression model in which public spending depends on the perceived price of public services and other demand variables. The authors construct a perceived price term that provides a more general framework for testing together several hypotheses of fiscal illusion. The perceived price depends on public revenues, decomposed into nine revenue sources, and is a weighted average of how fully taxpayers recognize the cost of each revenue source. For a sample of the 10 Canadian provinces from 1961 to 1992, the authors find that revenue structures influence spending, that tax revenues are perceived more acutely than other major revenue sources (borrowing, grants), and that some taxes are recognized more than others. The results can be viewed as consistent with debt illusion, flypaper, and income-elastic versions of fiscal illusion while casting doubt on using the Herfindahl index to represent fiscal illusion. The authors also find learning by taxpayers (declining fiscal illusion) during the period.